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Commission Issues New Rules to Bar Naked Short SalesSubmitted by: Subodh Mishra, Governance Institute

The SEC said Sept. 17 that it would move to prevent naked short sales of all publicly traded companies in a bid to calm jittery markets reeling from upheavals in the U.S. financial sector.

Earlier this summer, the commission had barred naked short sales on 19 financial stocks under an emergency authority that expired Aug. 12. This week?s market turmoil may have forced the commission to extend the rule far more broadly than expected.

?These several actions today make it crystal clear that the SEC has zero tolerance for abusive naked short selling,? SEC Chairman Christopher Cox said in a statement.

In a standard short sale, the seller borrows a stock and sells it, with the understanding that the loan must be repaid by buying the stock in the market. But in an abusive naked short transaction, as defined by the SEC, the seller does not actually borrow the stock, and fails to deliver it to the buyer. For this reason, commission officials argue, naked shorting can ?allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.?

The commission adopted three rules designed to address specific concerns related to naked short selling. The first rule would require short sellers and their broker-dealers to deliver securities by the close of business on the settlement date (three days after the sale transaction date, or ?T+3?) and impose penalties for failure to do so.

The second would mandate options market makers to abide by the hard T+3 closeout requirements that effectively ban naked short selling, while the third, Rule 10b-21, addresses fraudulent actions tied to naked short selling. Specifically, it covers short sellers who ?deceive broker-dealers or any other market participants,? and clarifies that those who ?lie about their intention or ability to deliver securities in time for settlement? will be in violation of the law when they fail to deliver.

Today?s actions will be welcomed by the business community and on Capitol Hill where lawmakers have been pressing the SEC to take action on naked short sales and other activities deemed to increase market volatility.

In a Sept. 16 press conference, Senate Banking Committee Chairman Christopher Dodd, D-Conn., told reporters he was disappointed with the SEC?s inaction over naked short selling and called on Cox to address the issue urgently in light of market turmoil.

Meanwhile, corporate law firm Wachtell, Lipton, Rosen, & Katz this week called on the SEC not only to extend its emergency order on naked short selling to all companies, but also to reinstate the so-called Uptick Rule, which has regulated short selling since the late 1930s. The rule, which mandated that short sales only be allowed when a share was trading up and was designed to prevent precipitous declines in share price due to shorting, was eliminated last summer. The SEC believed the 70-year-old rule was antiquated and took the step last July after running a pilot program to gauge its efficacy in regulating modern capital markets.

?The limitations of the SEC?s pilot program, which was conducted in a period of a rising market and unusually low volatility, are painfully clear,? Wachtell attorneys Edward D. Herlihy and Theodore A. Levine wrote in a Sept. 16 memo to clients. ?The risks associated with unrestricted short selling in these periods of high volatility and large market declines were necessarily beyond the pilot?s scope.?

Full post as published by Institutional Shareholder Services -- Corporate Governance Blog on September 17, 2008 (boomark / email).